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IRS Proposes Regulations on Treaty Benefits for Payments by 'Reverse Hybrid' US Entities

by Michael J. Miller
Published: June 01, 2001
Source: Canadian Tax Journal

The IRS has proposed regulations governing the qualification for treaty benefits of US-source payments by "reverse hybrid" US entities to their foreign interest holders. These proposed regulations would generally allow such payments to qualify for treaty benefits, but would recharacterize certain otherwise deductible payments by the reverse hybrid entity to related parties as dividends, eliminating the deduction and typically increasing US withholding tax.

On February 26, the Internal Revenue Service (IRS) published proposed regulations ("the new proposed regulations") governing the qualification for treaty benefits of US-source payments by "reverse hybrid" US entities (USRHEs) to non-US ("foreign") interest holders (FIHs) in such entities. For this purpose, a "reverse hybrid" is an entity that is characterized as a corporation for US tax purposes and as a partnership (or disregarded entity) for foreign tax purposes.

The new proposed regulations are to apply to payments made by USRHEs on or after the date that the final regulations are published in the Federal Register, with respect to payments received by the USRHE on or after the date of such publication. Before the specific provisions of the new proposed regulations are addressed, a brief description of the existing regulations and other background may be helpful.

Background

On June 30, 1997, the IRS issued temporary regulations under Section 894 of the Internal Revenue Code,(1) relating to eligibility for treaty benefits of payments of US-source income to certain entities.(2) These temporary regulations generally provided that a payment received by an entity (whether US or foreign) will be eligible for a reduced rate of, or exemption from, US tax under a treaty only if, among other requirements, the payment is treated as "derived by" a resident of an applicable treaty jurisdiction.(3) For this purpose, the temporary regulations generally considered a payment to be derived by a resident of an applicable treaty jurisdiction only to the extent that the payment is "subject to tax" in the hands of a resident of that jurisdiction.(4)

On the basis of these general principles, a payment made to a USRHE might appear to qualify for treaty benefits if an FIH is a resident of a treaty jurisdiction and is subject to tax by that jurisdiction on its proportionate share of the payment. The temporary regulations provided, however, that a treaty could not apply to reduce the amount of US tax otherwise imposed on payments made to any entity treated as a domestic corporation for US tax purposes, including a USRHE.(5) The temporary regulations did not address the potential availability of treaty benefits for amounts paid by a USRHE to an FIH.

In the absence of such guidance, commentators expressed doubt as to whether amounts paid by a USRHE to an FIH could be considered received by, or subject to tax in the hands of, the FIH. Since the FIH's jurisdiction generally treats the FIH as having received income subject to tax when an amount is paid to the USRHE, it would not appear that the FIH's jurisdiction could also treat the FIH as having received income subject to tax later, when the USRHE makes a corresponding payment to the FIH. Because the payment made by the USRHE apparently would not be considered received by, or subject to tax in the hands of, the FIH, treaty benefits would appear to be unavailable, even though the FIH's jurisdiction imposed tax on the related payment received by the USRHE. Of course, this result appears inequitable: an FIH in this situation would potentially be subject to double taxation, but would fail to satisfy the technical requirements for relief from US tax solely because it was subject to foreign tax prematurely.

The temporary regulations were finalized on July 3, 2000.(6) The final regulations confirmed the position taken in the temporary regulations with respect to payments received by USRHEs, and expressly reserved on the treatment of payments made by USRHEs to their interest holders.(7)

The New Proposed Regulations: General Rule

The new proposed regulations fill the gap left by both the temporary and the final regulations, by providing guidance for payments made by USRHEs. Subject to an anti-abuse rule described below, the new proposed regulations provide that an item of income paid by a USRHE to an interest holder therein will be characterized solely under US law.(8) For example, if a USRHE receives dividends from an unrelated US corporation and makes an interest payment to an FIH, the payment to the FIH will be respected as an interest payment, even if the FIH's jurisdiction considers the FIH to have received a dividend.(9) Thus, assuming for the moment that treaty benefits were available with respect to the payment, the interest article (rather than the dividends article), of the applicable treaty would determine the rate of US withholding tax imposed (if any).

The new proposed regulations also provide that a payment by a USRHE to an interest holder therein will be treated as "derived by" the interest holder as long as the interest holder is not fiscally transparent in its jurisdiction with respect to that item of income.(10) For this purpose, the determination of whether the interest holder is fiscally transparent is made as if the USRHE were not fiscally transparent under the laws of the interest holder's jurisdiction.(11) Accordingly, if a US corporation pays a US-source dividend to a USRHE and the USRHE pays a corresponding dividend to an FIH, the latter dividend may qualify for a reduced rate of US withholding if the FIH resides in a jurisdiction that has a tax treaty with the United States and the FIH is not considered fiscally transparent by that jurisdiction.

If the FIH is considered fiscally transparent by that jurisdiction, however, then a literal reading of the new proposed regulations suggests that treaty benefits will not be available (because the FIH will then not be considered to derive the income), even if the interest holders in the FIH are not fiscally transparent and are residents of the same jurisdiction (or of another jurisdiction that has a tax treaty with the United States and subjects them to tax on amounts paid to the FIH). This apparent limitation on treaty benefits serves no discernible policy objective, apart from simplicity, and may well have been unintentional.

Anti-Abuse Provision

The IRS and the Treasury department were concerned that under the general rules described above, USRHEs would be established by related parties to manipulate differences between US and foreign tax classification rules "to reduce inappropriately the amount of tax imposed on items of income paid from the United States to foreign interest holders."(12)

In a typical transaction, for example, a foreign resident of a treaty jurisdiction could establish a USRHE, capitalized with a combination of debt and equity and used to hold all of the stock of a US operating company. The operating company could pay a dividend to the USRHE, and the USRHE could make payments of at least partially deductible interest to the FIH.(13)

In such a case, the FIH's jurisdiction would normally view the FIH as receiving the dividend payment, and, absent a special rule, the US would view the USRHE as receiving a dividend tax-free and then making an at least partially deductible interest payment. In circumstances in which the applicable treaty provides for a complete exemption from withholding on interest and a 5% withholding rate on related-party dividends, the USRHE could claim an interest deduction while the FIH avoids US withholding tax altogether on the dividends that its own jurisdiction considers it to have received. In addition, the FIH could normally obtain either a tax credit or an exclusion of the dividend amount in its jurisdiction.

The IRS and Treasury considered these results to be inappropriate. More generally, the preamble to the new proposed regulations states that "the IRS and Treasury believe that it is inappropriate for related parties to use domestic reverse hybrid entities for the purpose of converting higher taxed US source items of income to lower taxed, or untaxed, US source items of income." As expressed in the preamble to the new proposed regulations, the IRS and Treasury are said to believe that allowing such conversion would defeat the expectations of the United States and its treaty partners that treaties be used "to reduce or eliminate double taxation for legitimate transactions, not to reward the manipulation of inconsistencies in the laws of the treaty partners."

Similarly, the preamble claims that the IRS and Treasury are concerned about the ability of foreign acquiring entities to obtain tax-advantaged financing through the use of USRHEs that exploit differences between US and foreign law, because this would unfairly disadvantage similarly situated domestic acquirors.(14)

Accordingly, the new proposed regulations set forth an anti-abuse rule. The anti-abuse rule only applies where (1) a domestic entity makes a payment to a related USRHE that is characterized as a dividend under the laws of either the US or the jurisdiction of a related FIH, (2) the related FIH is treated as deriving its proportionate share of the payment under the laws of its jurisdiction, and (3) the USRHE makes a payment to the related FIH (4) "of a type that is deductible for US tax purposes" and (5) for which a reduction in the US withholding tax rate would otherwise be permitted.(15) Where all five of these requirements are met, all or a portion of the payment by the USRHE to the related FIH is recharacterized as a nondeductible dividend payment for all purposes of the Code.(16) The portion of the payment that is recharacterized will not exceed the FIH's proportionate share of any payments previously made by the related domestic entity to the USRHE and treated as dividends under the laws of either jurisdiction.(17)

The new proposed regulations provide no guidance as to when a payment will be considered "of a type that is deductible for US tax purposes[.]" Accordingly, a question may arise where a special rule disallows a deduction for a payment that, under general rules, would give rise to a deduction. It seems likely that a payment would not qualify as "of a type that is deductible for US tax purposes" if a special rule permanently disallows any deduction for such expense.(18) If, however, the special rule merely disallows the deduction for the current year, but potentially allows the deduction in a later year, it seems likely that the payment would qualify and would be subject to recharacterization under the anti-abuse rule."(19)

Any amount recharacterized as a dividend under this rule will be treated as such for the purposes of applying the applicable treaty to determine the proper withholding rate, and, as noted above, for all purposes of the Code as well. The authority for such an all-purpose recharacterization rule is doubtful, so a challenge of this aspect of the new proposed regulations should be expected. In this respect, it should be noted that Code Section 894(c) expressly authorizes the promulgation of regulations only with respect to "any payment received by, or income attributable to any activities of, an entity organized in any jurisdiction (including the United States) that is treated as a partnership or is otherwise treated as fiscally transparent for purposes of this title . . . and is treated as fiscally nontransparent for purposes of the laws of the jurisdiction of residence of the taxpayer." This grant of authority does not apply to payments by reverse hybrid entities.(20)

It is possible that, in certain unusual situations, a taxpayer will wish to affirmatively apply the anti-abuse rule. For example, under certain treaties the withholding rate on dividends is lower than the withholding rate on interest payments.(21) Nothing in the new proposed regulations themselves expressly requires the commissioner of the IRS to make any determination, or take any action, in order for the anti-abuse rule to apply.(22) Accordingly, subject to the additional anti-abuse provisions described below, it appears that a taxpayer should be permitted to affirmatively apply this rule in order to recharacterize a payment by a USRHE as a dividend for treaty purposes.(23)

Additional Anti-Abuse Rules

As explained above, the anti-abuse rule requires, among other things, that the USRHE receive a payment from, and make a payment to, a related party. In order to prevent avoidance of the anti-abuse rule through the use of friendly but technically unrelated entities, the new proposed regulations would provide that if a person enters into a transaction (or series of transactions) with a USRHE, its related interest holders, or its related entities, and the effect of the transaction (or series of transactions) is to avoid the principles of the anti-abuse rule, then that person will be treated as related to the USRHE for the purposes of the anti-abuse rule (the deemed-related rule).(24) In addition, the new proposed regulations give the commissioner of the IRS the broad authority to recharacterize, as he or she deems appropriate, for all purposes of the Code,(25) any transaction (or series of transactions) between related parties if the effect of the transaction (or series of transactions) is to avoid the principles of the new proposed regulations (the recharacterization rule).(26) In each case, these are objective tests which require no tax-avoidance purpose.(27)

Although the IRS and Treasury understandably desire the flexibility to deal with a variety of transactions that cannot be identified at present, in practice it will be impossible to determine whether the effect of a transaction (or series of transactions) is to "avoid the principles" of the anti-abuse rule, specifically, or the new proposed regulations, generally. The new proposed regulations reflect a balancing of competing considerations, and provide no guidance as to how these considerations should be resolved in the case of fact patterns that are not specifically addressed.(28) It remains to be seen how aggressively the IRS will apply these "backstop" anti-abuse provisions and whether uncertainty in this regard will have any chilling effect on legitimate business transactions.(29) Assuming that the same "broad brush" approach is ultimately retained in the final regulations, taxpayers and practitioners can only hope that meaningful guidance will be provided in the form of additional examples.(30)

As a withholding agent, a USRHE will be placed in a difficult position with respect to payments that it reasonably deems to qualify under a treaty for a reduction in (or exemption from) U.S. withholding tax, because it will be exposed to liability for underwithholding if the IRS ultimately disallows such benefits pursuant to the backstop anti-abuse rules described above. In light of the highly uncertain (if not arbitrary) nature of these rules (which do not require any tax-avoidance purpose),"strict liability" for any such underwithholding seems particularly inappropriate.(31) In the absence of a safe harbor, however, this result appears to be unavoidable. If the new proposed regulations are finalized in substantially their current form, it is likely that their validity will be challenged. As noted above, Code Section 894(c) does not expressly authorize the promulgation of regulations for payments by reverse-hybrid entities.

FOOTNOTES_________________

1. Internal Revenue Code of 1986, as amended (herein referred to as "the Code"). Unless otherwise stated, statutory references in this article are to the Code.

2. TD 8722, 1997-2 CB 81.

3. Temp. Treas. Reg. Sec. 1.894-1T(d)(1). See also Peter A. Glicklich and Ellen Seiler Brody, "New US Withholding Rules for Hybrids and Passthroughs," Selected US Tax Developments feature (2000), vol. 48, no. 4 Canadian tax Journal 1345-55.

4. Temp. Treas. reg. section 1.894-1T(d)(1). For this purpose, the temporary regulations further provided that a payment received by an entity that is considered "fiscally transparent" by the applicable treaty jurisdiction is treated as subject to tax in the hands of a resident of the jurisdiction to the extent that the interest holders in the entity (other than interest holders that are themselves fiscally transparent) are residents of the jurisdiction. Ibid. A payment received by an entity that is not considered fiscally transparent by the applicable treaty jurisdiction is treated as subject to tax in the hands of a resident of that jurisdiction if the entity is itself a resident of the jurisdiction. Ibid. For the purposes of these rules, an entity is considered fiscally transparent with respect to an item of income to the extent that the jurisdiction requires interest holders in the entity to take into account separately, on a current basis, their respective shares of the items of income paid to the entity and to determine the character of such items as if the items had been realized directly from the source from which they were realized by the entity. Temp. Treas. Reg. Sec. 1.894-1T(d)(4)(ii).

5. Temp. Treas. Reg. Sec. 1.894-1T(d)(3). As indicated in the preamble to the new proposed regulations, the rationale for this rule is that the US retains full taxing jurisdiction over items of income received by its residents. For example, the "savings clause" in Article XXIX(2) of the income tax treaty in effect between the United States and Canada generally permits the US to retain full taxing jurisdiction over its citizens (as well as certain former citizens) and domestic corporations, even if they would otherwise be entitled to a reduction in US tax under the treaty. See the Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1985, March 17, 1995, and July 29, 1997 (herein referred to as "the Canada-US treaty").

6. TD 8889, 2000-30 IRB 124.

7. Treas. Reg. Sec. 1.894-1(d)(2). Certain technical changes made by the final regulations are not described herein.

8. Prop. Treas. Reg. Sec. 1.894-1(d)(2)(ii)(A).

9. It should be noted, however, that an interest payment may be treated as a dividend if (1) the putative indebtedness with respect to which the payment is made is recharacterized as equity under "substance over form" principles, or (2) the indebtedness with respect to which the payment is made qualifies as an "applicable high-yield discount obligation" and certain other requirements are satisfied. See Code Sec. 163(e)(5) and (i).

10. Prop. Treas. Reg. Sec. 1.894-1(d)(2)(ii). Under the final regulations, the term "fiscally transparent" has essentially the same meaning as under the temporary regulations, although several changes (not described herein) were made to clarify technical issues. Treas. reg. section 1.894-1(d)(3)(ii) and (iii).

11. Prop. Treas. Reg. Sec. 1.894-1(d)(2)(ii)(A).

12. See the preamble to the new proposed regulations.

13. In certain circumstances, Code Section 163(j) will limit the amount of interest that may be deducted.

14. Indeed, this is not the first time that the US tax authorities have expressed concern about allowing undue tax benefits to foreign acquirors of US corporations. The Tax Reform Act of 1986 enacted certain "dual consolidated loss" rules, prohibiting a dual-resident company (that is, one subject to worldwide taxation by both the US and a foreign country) from utilizing its losses to offset income on both a US and a foreign consolidated return. Thus, a UK corporation that forms a dual-resident subsidiary to acquire a US target corporation would not be able to use the dual-resident corporation's losses (for example, interest expense on the acquisition indebtedness) to offset both the UK parent corporation's income in the UK and the US target subsidiary's income in the US. In the absence of the dual consolidated loss rule, the corporate group could, in certain circumstances, earn a net profit and avoid paying taxes in either jurisdiction by double dipping on the interest expense. See United States, Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 100th Congress, 1st Sess., (May 4, 1987) 1064-65.

15. The definition of "related" for this purpose is technical, but generally requires 80% ownership (directly, indirectly or through the application of certain attribution rules). Prop. Treas. Reg. Sec. 1.894-1(d)(2)(ii)(B)(3).

16. Prop. Treas. Reg. Sec. 1.894-1(d)(2)(ii)(B)(1).

17. Ibid. For purposes of determining the amount otherwise recharacterized under this rule, the portion of the payments treated as derived by the related FIH is reduced by the amount of any prior actual dividend payments by the USRHE to the related FIH (including any payments recharacterized as dividends pursuant to prior applications of this rule). Ibid.

18. Thus, for example, any interest paid or accrued on a "disqualified debt instrument," for which a deduction would be permanently disallowed pursuant to Code Section 163(l), would probably not be subject to recharacterization under the anti-abuse rule. The same result should obtain in the event of payments for which deductions are permanently disallowed under other provisions, for example, Code Section 265(a)(2) (which disallows deductions for certain interest expense relating to tax-exempt income) and Code Section 269 (which disallows deductions relating to certain tax-motivated acquisitions of control of a corporation).

19. Thus, for example, any "disqualified interest" for which a deduction would otherwise be deferred under the "earnings-stripping" rules of Code Section 163(j) would likely be subject to recharacterization under the anti-abuse rule. The same result should obtain in the event of payments for which deductions are deferred under other provisions, for example, Code Section 267(a)(3) (which defers the deduction for accrual-basis taxpayers of amounts owned to related foreign persons until payment is made).

20. Of course, the IRS would presumably argue that it is authorized to promulgate such rules under Section 7701(l) (which expressly authorizes regulations recharacterizing multiple-party financing transactions as a transaction among two or more of such parties where appropriate to prevent the avoidance of tax) or Code Section 7805(a) (which generally authorizes all needful rules and regulations for enforcement of the Code.).

21. The Canada-US treaty, for example, provides for a maximum withholding rate of 5% on dividends paid to a corporate 10% shareholder and 10% on interest payments. Similarly, under the treaty in effect between the United States and Belgium, the maximum withholding rate is 5% on dividends paid to a corporate 10% shareholder and 15% on interest payments.

22. In this respect it should be noted that although the term "anti-abuse rule" is used liberally herein, the term does not appear in either the new proposed regulations or preamble; the new proposed regulations merely set forth an exception to the general rule where the five requirements described above are satisfied.

23. The preamble states that "a taxpayer may not affirmatively use the rules of [the new proposed regulations] if a principal purpose for using such rules is the avoidance of any tax imposed by the Code." This statement, which may be misleading, appears to be a reference to the commissioner's discretion, pursuant to an additional anti-abuse provision (described below), to recharacterize transactions that he or she deems to be inconsistent with the principles of the new proposed regulations. This provision is not self-executing, however, and, absent an exercise of such discretion by the commissioner, should not preclude a taxpayer from utilizing any advantageous provisions of the new proposed regulations. The statement in the preamble may also refer to the provision (described below) which would treat an unrelated party as related in certain circumstances, but this provision should not preclude application of the anti-abuse rule.

24. Prop. Treas. Reg. Sec. 1.894-1(d)(2)(ii)(B)(3).

25. As noted above, it is not clear that Code Section 894 authorizes any recharacterization of payments for all purposes of the Code.

26. Prop. Treas. Reg. Sec. 1.894-1(d)(2)(ii)(C).

27. As noted above, the preamble's suggestion to the contrary does not appear to be accurate.

28. Very few anti-abuse regulations are as broad and largely standardless. One well-known example is the partnership anti-abuse rule, which permits the commissioner to recast a transaction in which a partnership is formed or availed of with a principal purpose to reduce the present value of the partners' aggregate federal tax liability in a manner that is "inconsistent with the intent" of the partnership provisions of the Code. Treas. Reg. Sec. 1.701-2(b). See also Treas. Reg. Sec. 1.1502-20(e)(1) (which provides that "[i]f the taxpayer acts with a view to avoid the effect of [a loss-disallowance provision of the consolidated return regulations], adjustments must be made as necessary to carry out their purposes.").

29. In addition, certain structures that are arguably abusive may nevertheless be respected since they appear to be faithful to the principles of the anti-abuse rule. For example, by setting an 80% ownership threshold for related-party status (see Prop. Treas. Reg. 1.894-1(d)(2)(ii)(B)(3)), the new proposed regulations appear to contemplate that a deductible payment to an FIH that only satisfies an 79% ownership threshold (and therefore is not quite "related") will not normally be subject to recharacterization.

30. It is notable that the provision of numerous examples illustrating the partnership anti-abuse rule has alleviated much (although not nearly all) of the initial trepidation regarding its potential application to common partnership transactions.

31. In contrast, the "conduit rules," promulgated under Code Section 7701(l), provide certainty as to whether two parties will be considered related and significantly more guidance as to both the type of transaction subject to recharacterization and the specific effects of such recharacterization. See generally Treas. reg. section 1.881-3.